Description

Minosa wrote up TGT from the long side at $56 last May, in a timely trade. I think the risk reward is tilted the other way now and recommend a short in the stock.   

This pitch has no unique insights/variant perception – brick and mortar retail is structurally screwed. Target is no exception – the company is poorly positioned and all of its key operating metrics have shown signs of deterioration and are unlikely to reverse any time soon.  Somehow the stock trades near its all time high, presumably due to the one time tax windfall and buyback. I believe TGT will continue to be squeezed from all angles by the usual suspects – AMZN, WMT, off-price, $ stores, etc. In essence, I am betting the tax windfall will be competed away in 2-3 years. Aside from tax, almost every line in P&L will go against the company in 2018 and beyond, and margin/ROIC will continue to decline. Consensus estimates still have them grow EPS beyond ’18, while I think it will trend towards core EPS of $4 in 2020 (almost there in ’17 before the tax change). If I am wrong, TGT will hold EPS flat at best and stock already trades at 14x EPS for a no growth retailer. If I am right, stock should go to 10x on declining EPS (like BBBY). A recession will just accelerate the inevitable. I also like the idea does not have some of the typical risks associated with shorts -- this is no open-ended growth story, margins are still high, and market cap dictates there should be minimal take-out risk. The company does own the majority of its stores, but this once popular investment angle is dead for obvious reasons.  

Target needs no in-depth introduction. It operates 1822 big-box stores and owns 1526 of those stores. Sales are evenly split amongst 5 key categories – household, food & beverage, apparel, home furnishing, and hardlines. Digital sales were 5.5% of total sales in 2017. The one unique factor about TGT is that 1/3 of its sales come from owned and exclusive brands, which historically gave its “Tarjhay” image and partially explains much of its attractive margin/return profile.

The gist of the short is that I believe TGT will continue to see margin compression across the P&L. The starting point is TGT did $300 sales/sqft @ 6% op margin vs. $450/sqft for Walmart US @ 5.6% op margin in 2017. Store growth is muted so sales growth entirely depends on SSS. Reported SSS was 1.3% in 2017 and 3.6% in Q4, but that was mostly driven by digital channel and store SSS were 1.3%, -1.5%, 0.1% last 3 years. There has been some improvement in traffic recently, but the macro environment is arguably as good as it gets at this point of the cycle. There is simply no way store model could leverage on flattish SSS, and it’s almost inevitable the store SSS will turn negative. On gross margin, TGT saw 50bps compression in ’16 (adjusted for Pharmacy sale) and 40bps in ’17. One driver is the secular pressure of increased digital fulfillment costs – TGT is late to the online shift and sub scale vs. WMT/AMZN. Core merchandise margin will also see pressure as TGT’s price basket is consistently 5-10% higher than competitors, a gap that should become increasingly unsustainable particularly since WMT continues to make price investments (24bps compression in 2017 in WMT US segment). On SG&A, minimum wage going from $11 to $12/hour in ’18 alone would be almost $200m or 30bps headwind. D&A should also ramp up with recent increase in capex, going from $1.5B in ’16 to $2.5B in ’17 to $3B in ’18. Putting everything together, I see op margin going down 40-50bps annually next 2-3 years on still relatively benign SSS assumption, which obviously could get a lot worse in a recession.

I am somewhat surprised to see the delta between my out-year estimates and street numbers, as I don’t think my inputs are that draconian. I couldn’t find anything from mgmt’s strategies/initiatives to persuade me they could turn around the topline/margin trajectory. Somehow management guidance for this year assumes flattish margins on LSD SSS growth. Stock will react to the quarterly SSS fluctuation as usual, but I think the LT path is fairly certain.  

B/S has net debt of $9B, although I don’t think the company will be distressed any time soon. Interestingly, TGT bonds had traded down earlier this year and stayed down. FCF had been used to pay a 3.4% dividend and fund buyback, although mgmt is ramping up capex to fund store remodels and IT investments, likely at very poor ROIC (PS. I love how mgmt show attractive ROIC in the 10K using distorted tax rate in ’17). The increase in capex will put a cap on FCF and reduce capacity for buyback – I view buyback at current price/margin as ultimately value destructive. For what is worth, I think ESL was absolutely correct in not reinvesting in Sears/Kmart stores. He just should not have bought back shares.

Catalyst

weak SSS/recession?